Many of the emerging economies of the last two decades are now ensnared by ‘the middle-income trap’, in which middle-income countries don’t quite push through to high income status. This column presents recent research suggesting that, if governments act early and decisively to improve access to advanced infrastructure, enhance the protection of property rights, and reform labour markets, trapped economies – like their East Asian counterparts in the 1990s – can push on through.

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In the postwar era, many countries have managed to quickly reach middle-income status, but few have gone on to become high-income economies1. Rather, after an initial period of rapid ascent, many countries have experienced a sharp slowdown in growth and productivity, falling into what has been called a ‘middle-income trap’:

The World Bank (2012) estimates that of 101 middle-income economies in 1960, only 13 became high income by 2008.

Stuck in the middle

Formal evidence on growth slowdowns2 and middle-income traps has suggested that at per capita incomes of about US$16,700 in 2005 constant international prices, the growth rate of per capita GDP typically slows from 5.6 to 2.1%.

Using regression and standard growth accounting techniques, recent analysis (Eichengreen, Park, and Shin 2011) suggests that growth slowdowns are essentially productivity growth slowdowns, whereby 85% of the slowdown in the rate of output growth can be explained by a slowdown in the rate of total factor productivity growth; much more than by any slowdown in physical capital accumulation.

What causes the trap?

A common explanation of growth slowdowns is based on a Lewis-type development process (Canuto 2011; Eichengreen et al 2011; and World Bank 2012):

Switching labour from low-productivity sectors (e.g. agriculture) to higher-productivity sectors (e.g. industry and modern services) provides a massive, but one-off, rise in per capita income.

The switch in this initial phase of development is triggered by the application of imported technologies adopted in sectors producing labour-intensive, low-cost products.

Productivity growth from sectoral reallocation and technology catch-up is eventually exhausted, while rising wages make labour-intensive exports less competitive on world markets – precisely at the time when other low-income countries become engaged in a phase of rapid growth.

Accordingly, growth slowdowns coincide with the point in the growth process where it is no longer possible to boost productivity by shifting additional workers from agriculture to industry and where the gains from importing foreign technology diminish significantly.

An overlapping generations perspective

We present an alternative characterisation of middle-income traps (Agénor and Canuto 2012)3. Our approach agrees with the idea that productivity slowdowns are a major cause of middle-income traps, but differs from the existing literature in terms of how to explain this and what public policies can do about it.

In particular, several factors may affect productivity growth, including individual decisions to acquire skills, access to different types of public infrastructure, and knowledge network externalities (defined as the possibility that a higher share of workers with advanced levels of education has a positive impact on performance, that is, the ability to benefit from existing knowledge, of all workers engaged in innovation activities)4.

By extension, there are a number of public policies that developing countries can employ to avoid or escape from middle-income growth traps. Such measures include developing advanced infrastructure in the form of high-speed communications networks, improving the enforcement of property rights through patent protections, and reforming labour markets to ensure that rigidities do not prevent the efficient firing and hiring of employees.

Fundamentally, these policies attract more high-ability workers into the design sector, improve productivity and wages in that sector, and increase a country’s capacity for innovation.

Access to advanced infrastructure

Escaping from a middle-income trap may be achieved by a sufficiently large increase in investment in advanced infrastructure, particularly in high-speed communications networks. The availability of good-quality information and communications infrastructure play an important role in fostering innovation, both by facilitating the cheap circulation of disembodied knowledge flows across and within national borders as well as by reducing the transaction costs of international trade and foreign investment. Thus, improving access to advanced infrastructure boosts productivity and wages in the design sector, which draws more labour and triggers the shift in labour supply, magnifying – at least temporarily – the benefit associated with exploiting the existing stock of ideas.

Enforcement of property rights

To create incentives for individuals and firms to engage in innovation and design activities, the enforcement of patents is essential; however, this is often lacking in developing countries. A poorly functioning system to administrate patents and enforce property rights may create a deadweight loss for the economy and make it more likely for countries to be caught in a middle-income trap. Conversely, improved enforcement of property rights enhances innovation and translates into higher wages in the design sector, which would draw more high-ability workers into that sector.

Consequently, it is more likely that the knowledge network externalities alluded to earlier would kick in and set the economy on a path to higher productivity and output growth.

Labour market reforms

By exacerbating the misallocation of talent, labour market distortions may make it more likely that the economy will end up in a lower-growth equilibrium. To be sure, some types of labour market restrictions, especially those on firing costs, may be particularly detrimental to design or innovation activities. The reason is that in such activities, it is often more difficult to observe the productivity of a worker before hiring – in contrast to routine tasks in manufacturing, where your ability to observe, both ex ante and ex post, is less costly. Thus, the risk of hiring a worker who turns out to be a poor performer is higher in activities where a college degree does not necessarily provide a reliable signal about future performance. In such conditions, the labour market distortion acts as a disincentive to seek higher education, with adverse consequences for innovation and growth.

Middle income traps and the East Asian experience

As mentioned earlier, only 13 countries were able to transition from middle- to high-income status since the 1960s. Of these countries, five were from East Asia – Hong Kong SAR (China), Japan, Korea, Taiwan, China, and Singapore – four of which comprise the so called ‘Asian Tigers’. Given their success, let’s reflect on their experience in order to draw lessons for other middle-income countries seeking to move into high-income status. Many of the public policies highlighted above – as well as a larger framework for innovation based on technological learning and public sector support of research and development investments – can be extrapolated from the East Asian success story.

Of the East Asian economies that were able to escape the middle income trap, all have succeeded in developing advanced infrastructure, particularly in the form of high-speed communications networks and broadband technology.

For a number of countries, the evolution of these services has been fostered by the liberalisation of telecommunications markets and related regulatory framework reforms (Gill and Kharas 2007).

The success of the East Asian economies that were able to transition from middle- to high-income status was based on their ability to push the technological frontier and move from imitating and importing foreign technologies to innovating technologies of their own.

Strong protection of intellectual property rights has been a major factor in facilitating this home-grown innovation. According to the World Bank’s Doing Business Database7, intellectual property rights in economies such as Hong Kong SAR (China), Korea, Singapore, and Taiwan, China, rival those in place in Japan, the US, and other high-income countries. As a result of a well-functioning system of intellectual property rights protection, many countries in the region have also become global leaders in patenting their own technologies.

Flexible labour markets and open economic policies have allowed for the reallocation of labour across sectors within the most successful economies in the region.

Countries in the region have relied extensively on international trade to accelerate their labour transfer by inserting themselves into the labour-intensive segments of global value chains. Such a transfer was facilitated by advances in information and communication technologies, by decreasing transport costs and lowering international trade barriers (Canuto 2011). This labour market flexibility has facilitated a new labour transition that is increasingly directed toward innovative occupations.

Conclusion

The middle-income trap is avoidable if governments act early – rather than late, when the benefits of cheap labour and the gains from imitating foreign technology are all exhausted – and decisively to promote innovation.

Doing so requires timely implementation of public policies aimed at improving access to advanced infrastructure, enhancing the protection of property rights, and reforming labour markets. As the East Asian experience illustrates, such policies are central to fostering technological learning, attracting talented individuals into research and development activities, and encouraging the build-up of national and international knowledge networks.

References

Canuto, O, M Dutz, and J G Reis (2010), “Technological Learning and Innovation: Climbing a Tall Ladder”, In O Canuto and M Giugale (eds.) The Day After Tomorrow: A Handbook on the Future of Economic Policies in the Developing World, 51–66, Washington, DC, World Bank.

1 The term ‘middle income trap’ was apparently first used by Gill and Kharas (2007); see also Commission on Growth and Development (2008) ‘Middle-income economies’ are defined in accordance with the World Bank’s classifications by income group, as given here.
2 The authors define a growth slowdown based on three conditions: the first requires that prior to the slowdown, the seven-year average growth rate is 3.5% per annum or greater. The second condition identifies a growth slowdown with a decline in the seven-year average growth rate by at least 2 percentage points. The third condition limits slowdowns to cases in which per capita GDP is greater than US$10,000 in 2005 constant prices—thereby ruling out episodes related to countries that have not yet successfully developed.
3 Another view of the middle-income trap, which also focuses on occupational choices in a globalized world, is developed in Eeckhout and Jovanovic (2012).
4 Indirect evidence of the importance of (local) knowledge networks is provided by Weinberg (2011), who found that per capita GDP in developing countries is positively related to the number of important scientists born in and staying in a country.5 Of course, all production sectors (not only design activities) may benefit from advanced infrastructure. For instance, it is well documented that in recent years ICTs have helped integrate supply chains both within and across borders, thereby boosting efficiency in the production of manufactured goods (Canuto 2012). However, this does not affect the logic of this argument.
6 Imitation activities may take the form of task-based production, that is, specialization in some stage of a value chain rather than in final products. However, task-based production may reinforce a country’s specialization in low-technology, less sophisticated activities—which can be viewed as another form of a middle-income trap, that is, an ‘imitation trap’. The United Nations Industrial Development Organization (UNIDO 2009) compared the sophistication of product- and task-based manufacturing and found no evidence that task-based production is less technologically sophisticated than production of final products.
7 Doing Business Database, World Bank and International Finance Corporation,